After my 25 years in this business and seven years teaching at The Stillman School of Business at Seton Hall University, there is one thing that I can predict about the current earnings season. Actually, I can state it with 100% certainty: This earnings season will be unpredictable. They all are.The second quarter of 2009 will be further clouded by the enduring uncertainty of the deep recession. Every so often, one or two business sectors set the tone for earnings season. I believe that this time around there will be a great deal of focus on the financial services industry. This segment could determine if the recent market rally continues of if it falters. This group of companies has been hardest hit by the financial crisis and recession. During the quarter, many financial institutions have been able to raise additional capital and in some instances pay back loans received under the TARP program. Some of this may be factored into the recent rally in many of these stocks off of the March bottom. One of the first financials to report was Goldman Sachs ( GS), which announced on Tuesday. The company's better-than-expected earnings confirmed that Goldman has little or no risk, unlike other banks that are embroiled in the credit and mortgage crisis. Here are five factors that could determine the success or failure of this industry for the second quarter of 2009: 1. The industry as a whole, especially the larger and in some respects more-endangered institutions, has significantly increased its capital position through capital issuance and improved results. Tier 1 capital, which is the measure of a bank's core capital position, will be at significantly higher levels than it's been for the past few quarters. Expect improvements at Bank of America ( BAC), JPMorgan Chase ( JPM), State Street ( STT) and some regional banks.
2. Revenue growth should be robust for the industry. Several of the banks with broker-dealer and investment banking arms will be generating a huge amount of underwriting fees from what may have been the most prolific market for secondary issues in the history of capitalism. This one factor alone could be responsible for some unanticipated positive earnings surprises. A big underwriting winner here could be Morgan Stanley ( MS), which now also controls Smith Barney. Furthermore, the large double-digit increase in the equity averages, combined with fund inflows, will benefit investment managers, such as BlackRock ( BLK). 3. The TARP restrictions have resulted in far lower amounts of compensation expenses paid or accrued within the industry. This will also help bottom lines. While the untethering of many of these organization from TARP restrictions may result in an increase in future bonus payments from current levels, I am highly skeptical that they will return to 2006-2007 levels. 4. With the easing of market-to-market accounting rules, as promulgated by the Financial Accounting Standards Board under FAS 157, at the outset of the quarter, the magnitude of mortgage and derivative-related writedowns will be far less than it has been over the course of the past two years. I will venture a guess that some companies will be reclaiming prior negative marks into income. 5. Not all second-quarter earnings news will be positive for the industry. Increasing unemployment will lead to further credit card delinquencies, which will result in increased allowances and write-offs for bad debt. The larger credit and charge card companies such as American Express ( AXP), Capital One ( COF) and Citigroup ( C) could take some hits to results for expanding credit losses.
Identify the strengths and weakness of individual financial services companies. Try to focus on the trends and facts I outlined above to latch onto a potential investment or earnings-related event trade. Understand financial services balance sheets in great detail to appreciate many of the implications from the capital issuances and market-to-market rules changes.